Foreign Exchange Rates

When you travel to a foreign country, it is vitally important to understand the currency exchange rates between the various countries you visit. Perhaps you plan to travel to Canada or France and have to exchange Australian money for the foreign currency of that country. Maybe you have travelled from Japan to England and have to exchange yen for English pounds. These are instances of the different types of foreign exchange rates at work.

Technically, foreign exchange rates indicate how the monetary systems of the different countries compare in terms of value. Since the onset of a more global economy, foreign exchange rates have been utilized more to promote trade and maintain the stability of the global monetary system. Overall, the exchange rate indicates a national currency’s value with respect to the value of foreign ones.

A quotation is given in an exchange system, by indicating the number of “quote currency” units that have the potential to be exchanged for a single unit of “base currency.” The term, “quote currency” can be defined as price currency or payment currency, which the term, “base currency,” refers to unit or transaction currency. A convention in the finance market determines which is the term currency and which is the base currency.

There are four primary types of foreign exchange rates:

Fully Fixed

Fixed rates are one of the ways that any government can keep their monetary exchange rates fixed. Governments that use this rate tend to set the price of foreign money exchange at well below the market clearing prices. This means that they set their own money prices too high
Rates that can be converted toward another currency directly are called, “Fixed rates.” This occurs when foreign reserves back a domestic currency one to one. Countries that adopt another country’s currency while abandoning its own fall under this category.

The main advantage of fixed rates is that they provide greater degree of certainty for importers and exporters. Less speculative activity occurs in most cases, although this fully depends upon whether dealers in foreign exchange markets regard a given fixed exchange rate as credible and appropriate.

Semi-fixed or Flexible

Flexible exchange rates occur when countries neither announce nor take steps to enforce a given exchange rate. In other words, the relative price of a currency is determined directly in the marketplace through the selling and buying of businesses and households. Japan, Canada and the United States currently utilize flexible exchange rate systems.

Free Floating

The most common exchange rates are called, “floating rates.” The British pound, euro, yen and the dollar all float. This type of rate is often referred to as managed or dirty float rates due to the frequent intervention of central banks.

The advantages of free floating foreign exchange rates is that they provide adjustments automatically for countries that have a large balance of payments deficit. This type of exchange rate also allows governmental monetary authority some flexibility to determine interest rates. This happens because there is no need for them to be used to influence the exchange rate.

Some economists consider floating exchange rates to be preferable to the fixed ones. This is because floating exchange rates adjust automatically and allow a country to lessen the impact of foreign business cycles and shocks. A floating exchange rate preempts the possibility of a crisis with payments and balances. This is true in most cases, but in specific situations, fixed rates may be preferable because of their greater certainty and stability.

The Mundell-Fleming model contends that any economy cannot maintain a fixed exchange rate, an independent monetary policy and free capital movement. Instead, it can pick any two for the control and leave the market forces the third one.

Pegged or Managed Float

Pegged float rates exist as a compromise between fixed rates and floating rates. Under the pegged rate regime, a country permits its money to fluctuate within a fixed area around a central value that is periodically adjusted. The primary advantage for the pegged float rate is that it provides opportunities for economic growth

The government of any country must work to maintain the stability of their pegged rate.
Large reserves of foreign currency must be held by the country’s national bank to moderate changes in supply and demand. If the exchange rate is driven up by a sudden demand for a particular currency, the national bank would be required to release enough of their currency directly into the market to meet with the demand. The country’s national bank is also able to buy currency if a low demand is further lowering the exchange rate.

As anyone can see the different types of foreign exchange rates serve specific purposes in the financial market.